Reform that Hurts Homebuyers

The 2010 Dodd-Frank Act is designed to purge unfair, deceptive, and exploitive financial products and practices from the financial markets. Included in the law is a provision not well known to the general public that could dramatically reduce availability of home-mortgage credit in America. The new law requires that mortgage firms hold a 5 percent share of the risk in loans they originate before the loans can be securitized or sold on the secondary market.

This provision, also known as having "skin in the game," is intended to give mortgage originators a stake in the performance of the loans they originate and thereby limit the kinds of reckless and unsustainable mortgage underwriting practices and products that were at the epicenter of the current foreclosure crisis. As Shelia Bair, chair of the Federal Deposit Insurance Corporation, has pointed out, almost 90 percent of the reckless subprime and Alt-A loan originations during the peak origination years of 2005 and 2006 were privately securitized through an "originate to distribute" model that rewarded loan volume rather than quality. This market structure misaligned the interests of loan originators in relation to investors and homeowners. But if not properly implemented, the supposed reform could further damage an already ailing housing market.

Dodd-Frank provides an exception to this risk-retention requirement for loans that meet a new definition of a Qualified Residential Mortgage. The QRM is intended to establish a class of loans that are considered low-risk based on underwriting and product features that historically have resulted in fewer defaults. These loans are considered so safe that they can be exempt from the 5 percent skin-in-the-game rule. Since lenders want to avoid the 5 percent risk-retention requirement, QRMs will set the standard for conventional mortgages and determine the loans that will most widely be available to consumers at the lowest costs.

Underwriting characteristics specified in Dodd-Frank to be considered in determining which loans meet the QRM standard include: the documentation of financial information used to qualify the borrower, debt-to-income ratios, product features, points and fees, and whether a loan has mortgage insurance or any other credit enhancement. In addition, certain loan characteristics are flatly prohibited from being included within the definition of a QRM, including negative amortization loans, balloon payments, and other inherently high-risk loan features.

Because multiple features influence loan performance, a multifactor approach is essential to avoid unnecessarily narrow, rigid, or arbitrary guidelines that could preclude homeownership for otherwise qualified borrowers. The FDIC released draft QRM rules on March 29 and has re-quested comments by the end of May. The draft represents the joint efforts of six federal agencies. Based on the draft recommendations, things do not look promising.

Under the rubric of discouraging dangerous practices, the draft rules establish narrow and rigid standards that threaten to slam the door to homeownership for millions of otherwise qualified borrowers while simultaneously failing to reduce the risks of default. The draft rules, for example, require a minimum down payment of 20 percent for qualified residential mortgages.

There is no reasonable justification for this rigid requirement. Safe, low down -- payment mortgages have been a vital part of America's homeownership success story for decades. And low down-payment mortgages have been essential in promoting sustainable homeownership for responsible moderate-income working families, minorities, and young adults in particular. In fact, even in the current conservative lending environment, the research firm CoreLogic estimates that almost 2.7 million borrowers put down less than 20 percent last year. And the Center for Responsible Lending estimates it would take the typical family 14 years to save for a 20 percent down payment on the median priced home.

Alternatively, individuals who do not have large amounts of savings would be required to pay substantially more for a loan or rely on the Federal Housing Administration. Loans guaranteed by the FHA are recommended to be exempt from the QRM. But the administration has already proposed, as part of its broader reform of the home-mortgage finance system, the reduction of loan volumes combined with increased fees at FHA.

Moreover, channeling borrowers to the FHA, which is a 100 percent federally guaranteed loan program, increases the federal government's liability for home loans, contradicting the stated goal of mortgage-market reform to have the private-sector assume more of the risk of mortgage lending. Another important and near-term exception in the QRM draft rules is that loans guaranteed by the government -- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are exempt from the QRM standards while they remain in government conservatorship. This would allow for continued low down-payment mortgages unless subsequent rule changes require higher down payments for loans guaranteed by the GSEs or the GSEs are dissolved, both of which have been proposed by the Obama administration.

The nation's housing bubble was allowed to inflate in plain sight for nearly a decade before busting -- to the apparent surprise of the financial regulatory agencies that were responsible for ensuring the safety and soundness of the financial system. Now, in response to the catastrophic collapse of the markets, financial regulators are intervening in a manner that could greatly stifle the housing market's correction and preclude millions of average Americans from accessing mortgage credit and the opportunity to become homeowners. The wrong kind of market regulation after the crash will not compensate for having missed the crisis in the first place.

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